Investment Management AUGUST 2003 CFTC Adopts Major Relief from CFTC Registration Requirements for Mutual Funds, Hedge Funds and Investment Advisers At a time when participants in U.S. securities markets face increasingly onerous regulatory burdens, the Commodity Futures Trading Commission (CFTC), on August 4, 2003, adopted rules that (1) expand the ability of registered investment companies (RICs) to use futures and commodity options without regulation as commodity pool operators (CPOs) and (2) lessen the registration and other regulatory requirements applicable to hedge fund operators, investment advisers and others who trade in futures and commodity options. In particular, the new rules: n Eliminate CFTC limitations on futures and commodity options trading activities by RICs, including RICs that invest in unregistered hedge funds. n Create exemptions from CFTC registration for persons who operate hedge funds, including an exemption permitting unlimited futures and commodity options trading activities for many 3(c)(7) funds and a more limited exemption for many 3(c)(1) funds. n Clarify that operators of hedge funds-of-funds, in determining compliance with a new CFTC registration exemption that includes a trading limitation, may rely on the representations of underlying fund managers. n Create new exemptions from CFTC registration for investment advisers who advise RICs and hedge funds. BACKGROUND The federal statute governing commodity trading is the Commodity Exchange Act. The CFTC is the federal agency that enforces the Commodity Exchange Act and issues regulations to implement its provisions. Persons required to register as commodities professionals under the Commodity Exchange Act also must become members of the National Futures Association (NFA), a commodity self-regulatory organization designated by the CFTC. Definitions. Investment advisers and other money managers commonly fall within two regulatory classifications under the Commodity Exchange Act: commodity trading advisors (CTAs) and/or CPOs. The Commodity Exchange Act generally defines a CTA broadly to include any person who (i) advises others, for compensation or profit, as to the advisability of trading in domestic exchange-traded futures contracts or commodity options that are regulated by the CFTC (such futures and commodity options being referred to herein as futures and commodity options, respectively), or (ii) as part of a regular business issues analyses or reports concerning such instruments. The definition of CTA thus encompasses not only persons whose primary business is to provide futures and commodity options trading advice, but also persons, such as investment advisers and banks, that provide futures and commodity options trading advice to their clients in connection with their general business of providing securities trading advice. Kirkpatrick & Lockhart LLP Similarly, the term CPO is defined very generally in the Commodity Exchange Act to include any person who pools client money for the purpose of trading in futures or commodity options. The definition covers persons who manage traditional commodity pools, as well as persons who, for example, operate RICs, hedge funds and bank collective funds that trade in futures or commodity options. Registration and Relevant Exemptions. Unless they are able to claim an exemption from registration, CPOs and CTAs are required to register with the CFTC and the NFA prior to acting as a CPO or CTA. Registration entails the completion of various forms using the NFAs new online registration system. The principals of the CPO or the CTA are subject to extensive background checks and are required to have passing scores on one or more examinations. The CFTC rules contain several exemptions and exclusions from CPO and CTA registration requirements. On October 28, 2002, November 6, 2002 and March 17, 2003, the CFTC proposed to expand the available exclusions and exemptions and, in some cases, included no-action relief allowing immediate reliance on the proposed rules. The CFTC adopted final rules on August 4, 2003, as discussed further below. RULE 4.5: FUTURES AND COMMODITY OPTIONS TRADING ACTIVITIES BY RICS AND OTHER REGULATED ENTITIES Background. Rule 4.5 excludes from the definition of CPO persons that operate pools that are regulated by some other regulatory authority. The following persons, and principals and employees thereof, are eligible to rely on Rule 4.5: n RICs, n Insurance companies subject to state regulation, n Banks, trust companies and other financial depository institutions subject to federal or state regulation, and n Trustees of, named fiduciaries of, and employers maintaining a pension plan that is subject to Title I of the Employee Retirement Income Security Act of 1974, as amended (ERISA). Each person listed above is excluded from the definition of CPO with respect to the operation of their respective qualifying entities. For a RIC, the qualifying entity is the RIC itself; for insurance companies, it is an insurance company separate account; for banks, trust companies and other financial depository institutions, it is the assets of any trust, custodial account or other separate unit of investment for which the bank is acting as a fiduciary with investment authority; and, for trustees of pension plans, it is a pension plan subject to Title I of ERISA. In the RIC context, Rule 4.5 operates to exclude the RIC from CPO registration. However, a RICs adviser and sub-advisers would still be CTAs and need an independent exemption from CTA registration. As discussed further below, CFTC Rule 4.14(a)(8) contains such an exemption but only for CTAs whose advice is directed solely to RICs or other specified entities. Prior Trading Limitations. To take advantage of the exclusion provided by Rule 4.5, the persons listed are required to file a notice with the CFTC and the NFA. Previously, this notice required the person to represent that it would operate the related qualifying entity in compliance with a limitation on the use of futures and commodity options for other than bona fide hedging purposes. The qualifying entity was required to represent that it would limit the aggregate initial margin and premiums required to establish any such non-bona fide hedging positions to 5% of the liquidation value of the qualifying entitys portfolio, after taking into account unrealized profits and unrealized losses on any such contracts into which it had entered. On October 28, 2002, the CFTC proposed an amendment to Rule 4.5 that would have created a new Notional Test for other than bona fide hedging positions, on which a qualifying entity could have relied as an alternative to the 5% test. Under the proposed Notional Test, a qualifying entity would have been required to represent that the aggregate notional value of its non-bona fide hedging futures and commodity options positions does not exceed the liquidation value of its portfolio, after taking into account unrealized profits and unrealized losses on any such contracts it has entered into. The October 28, 2002 proposing release included no-action relief permitting reliance on the Notional Test pending adoption of the final rule. Kirkpatrick & Lockhart LLP 2 Elimination of All Trading Limitations. As adopted, Rule 4.5 eliminates both the 5% test and the Notional Test. Thus, there are now no CFTC limitations on the use of futures or commodity options by qualifying entities. Among other things, this change makes it much easier to operate registered funds-of-funds whose underlying funds trade futures or commodity options. However, the ability of qualifying entities to use futures or commodity options may still be limited under other applicable laws and regulations, such as Section 18 of the Investment Company Act of 1940, as amended (1940 Act), in the case of RICs. Additionally, amended Rule 4.5 no longer contains the requirement that a qualifying entity not be marketed to the public as a commodity pool. However, qualifying entities are now required to disclose in writing to each participant that the qualifying entity is operated by a person who has claimed an exclusion from the definition of CPO under the Commodity Exchange Act and, therefore, is not subject to registration or regulation as a CPO. For a RIC, this disclosure should be contained in its prospectus or statement of additional information. RULE 4.13: EXEMPTIONS FROM CPO REGISTRATION FOR POOLS WITH SOPHISTICATED INVESTORS Exemption Requiring Lower Sophistication with Trading Limitation. New CFTC Rule 4.13(a)(3) exempts a CPO from registration if, among other conditions: n interests in the pool are exempt from registration under the Securities Act of 1933, as amended (Securities Act), and such interests are offered and sold without marketing to the public in the United States, n it restricts participation in the pool to (i) accredited investors as defined in Rule 501 under the Securities Act, (ii) certain family trusts formed by accredited investors, (iii) knowledgeable employees as defined in Rule 3c-5 under the 1940 Act and (iv) the CPO itself and certain other employees and affiliates of the CPO who are qualified eligible persons (QEPs) as defined in CFTC Rule 4.7(a)(2)(viii)(A), n at all times it limits the commodity interest positions (whether or not entered into for bona fide hedging purposes) in each of its pools such that either (i) the aggregate initial margin and premiums required to establish such positions will not exceed 5% of the liquidation value of the pools portfolio, after taking into account unrealized profits and losses, or (ii) the aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100% of the liquidation value of the pools portfolio, after taking into account unrealized profits and losses, and n the CPO does not market participations in the pool to the public as a commodity pool or otherwise as or in a vehicle for trading in the futures and commodity options markets. Qualifying entities remain subject to all relevant provisions of the Commodity Exchange Act and CFTC rules that apply to all commodity interest market participants, such as the general antifraud rules, the prohibitions on manipulation and the trade reporting requirements. In addition, qualifying entities relying on Rule 4.5 must continue to make a filing with the CFTC and the NFA. Ramifications. Now that the CFTC has eliminated all trading limitations under Rule 4.5, RICs should consider whether they should amend their prospectuses, statements of additional information (SAI) and, if applicable, fundamental or nonfundamental investment restrictions to reflect the expanded permitted use of futures and commodity options. New notices do not need to be filed with the CFTC or the NFA. However, if a RIC or other qualifying entity wishes to rely on the new rule (and eliminate any CFTC-related limitation on the use of futures and commodity options), it must amend its disclosures to comply with the new rules requirements. Kirkpatrick & Lockhart LLP 3 Exemption Requiring Higher Sophistication with No Trading Limitation. New Rule 4.13(a)(4) exempts a CPO from registration if, among other conditions: n interests in the pool are exempt from registration under the Securities Act and such interests are offered and sold without marketing to the public in the United States, and n it restricts participation in the pool to natural persons who are QEPs as defined in CFTC Rule 4.7(a)(2) and non-natural persons who are either QEPs or accredited investors as defined in Rule 501(a)(1)-(3), (a)(7) or (a)(8). This adopted exemption, unlike that adopted in Rule 4.13(a)(3), does not impose any limitations on futures and commodity options trading activities, ostensibly because the QEP sophistication standard for natural persons in Rule 4.13(a)(4) is higher than the sophistication standards in Rule 4.13(a)(3). It is significant that the exemption in Rule 4.13(a)(4) applies only to pools with natural persons who are QEPs by virtue of Rule 4.7(a)(2) and not also Rule 4.7(a)(3). In general, a natural person can be a QEP under Rule 4.7(a)(2) by being a qualified purchaser as defined in the 1940 Act, a knowledgeable employee, a Non-United States person, as defined in CFTC Rule 4.7(a)(1)(iv), or the CPO itself and certain other employees and affiliates of the CPO. By contrast, Rule 4.7(a)(3) contains a lower QEP eligibility threshold ($2,000,000 in investments as compared to the $5,000,000 required to attain qualified purchaser status). Thus, CPOs of most qualified purchaser Section 3(c)(7) hedge funds could in theory comply with the Rule 4.13(a)(4) exemption. Non-U.S. investors are typically QEPs by virtue of being Non-United States persons under CFTC Rule 4.7(a)(1)(iv). Accordingly, an offshore hedge fund that does not have any U.S. investors who are natural persons should also be able to qualify for the Rule 4.13(a)(4) exemption. Notice and Disclosure. The CFTC release notes that a pool operator could simultaneously operate a pool that relies on the exemption in Rule 4.13(a)(3) and one that relies on the exemption in Rule 4.13(a)(4). A registered CPO may also rely on these rules. For example, a CPO may operate a pool in compliance with Rule 4.13(a)(4) to avoid some of the periodic reporting requirements that are ordinarily applicable to a CPOs commodity pools. To avail itself of the exemption in either Rule 4.13(a)(3) or (a)(4), the CPO must file a prescribed notice with the NFA. In addition, it must disclose to each prospective participant in the pool: (1) a statement that the person is exempt from registration as a CPO and, unlike a registered CPO, is not required to deliver a disclosure document and a certified annual report to participants in the pool, and (2) a description of the criteria pursuant to which it qualifies for an exemption from CPO registration. The rule also contains certain recordkeeping and annual report requirements, and persons who rely on the rule are subject to special calls by CFTC staff. Persons who already claimed relief under the prior no-action position do not need to refile their claim. If, however, a person wishes to take advantage of the expanded relief, compliance with the revised disclosure requirements is required. APPLICATION OF RULE 4.13 TO FUNDS OF FUNDS The CFTC adopted a new Appendix A to Part 4 of the CFTC rules to address the application of the Rule 4.13(a)(3) trading limits in the context of funds-offunds (FOFs). Many CPOs operate commodity pools that do not invest directly in futures and commodity options but instead invest in one or more underlying funds that themselves trade in futures and commodity options. FOFs may invest in a dozen or more underlying funds and the operator of the FOF often has no affiliation with the operators of the underlying funds, thus raising the issue of how a FOF operator would determine compliance with the 5% or 100% limitation in Rule 4.13(a)(3). Appendix A generally provides that a FOF may rely on the representations of underlying funds in assessing the FOFs compliance with Rule 4.13(a)(3). For example, if a FOF invests exclusively in underlying funds that themselves comply with the trading limitation in Rule 4.13(a)(3), then the FOF itself would comply with the trading limitation in Rule 4.13(a)(3). Similarly, a FOF may comply with Rule 4.13(a)(3) by obtaining contractual assurances from its underlying funds regarding the futures and commodity options trading activities of the underlying funds and aggregating the percentage limitations to determine the FOFs compliance with Kirkpatrick & Lockhart LLP 4 the 5% or 100% limitation. Appendix A does note, however, that FOF operators must still comply with all of the other requirements of Rule 4.13(a)(3) to avail themselves of the exemption from CPO registration. RULE 4.14: EXEMPTIONS FROM CTA REGISTRATION Prior Rule 4.14(a)(8). Prior CFTC Rule 4.14(a)(8) exempted from registration CTAs that gave commodity interest trading advice solely to Rule 4.5 qualifying entities, and were registered as investment advisers with the SEC or excluded from the definition of investment adviser under the Investment Advisers Act of 1940, as amended (Advisers Act), pursuant to Section 202(a)(2) or Section 202(a)(11) (this exclusion includes certain banks, lawyers and other professionals, brokers, dealers and publishers). The prior Rule did not exempt smaller investment advisers (those with under $25 million in assets under management) that were registered with a state securities regulator and not with the SEC. Adopted Rule 4.14(a)(8). Amended Rule 4.14(a)(8) expands the CFTC exemption to cover U.S. stateregistered investment advisers and investment advisers that are exempt from federal and state registration. In addition, amended Rule 4.14(a)(8) extends the exemption to CTAs whose futures and commodity options trading advice is directed solely to (and for the sole use of): n CFTC Rule 4.5 qualifying entities for which notices of eligibility have been filed or that are excluded from the definition of the term commodity pool in CFTC Rule 4.5(a)(4), n CPOs that have claimed an exemption from registration under CFTC Rules 4.13(a)(3) or 4.13(a)(4), or n commodity pools organized and operated outside of the United States that meet the following conditions: o The CPO has not organized and is not operating the pool for the purpose of avoiding CPO registration; o With the exception of the pools operator, advisor and their principals, only NonUnited States persons (as defined in CFTC Rule 4.7(a)(1)(iv)) may contribute funds or other capital to, and own beneficial interests in, the pool; provided that units of participation in the pool held by persons who do not qualify as Non-United States persons or as QEPs may not represent 10% or more of the beneficial interests in the pool; o No person affiliated with the pool may conduct any marketing activity for the purpose of, or that could reasonably have the effect of, soliciting participation from other than Non-United States persons; and o No person affiliated with the pool may conduct any marketing activity from within the United States, its territories or possessions. To qualify for the exemption, a CTA also must limit its commodity interest trading advice to that which is solely incidental to its business of providing securities or other investment advice to the trading vehicles specified in the Rule, and it must not hold itself out as a CTA. A prescribed notice must also be filed with the NFA. The Rule also contains certain recordkeeping requirements, and persons who rely on the Rule are subject to special calls by CFTC staff. Persons who already claimed relief under the prior no-action position do not need to refile their claims. TREATING AN ENTITY AS A SINGLE CLIENT Section 4m of the Commodity Exchange Act provides that the registration requirements for CTAs do not apply to any CTA who, during the course of the preceding 12 months, has not furnished commodity interest trading advice to more than 15 persons and who does not hold itself out generally to the public as a CTA. For purposes of determining the number of persons a CTA advises, the CFTC staff has long interpreted the statute to require CTAs to look through any entities they advise (such as partnerships or corporations) and to count each limited partner, shareholder or other investor as a person advised by the CTA. As adopted, Rule 4.14(a)(10) eliminates this look through position. Under this Rule, any entity advised by a CTA that receives commodity interest trading advice based on its investment objectives, rather than on the individual investment objectives of its investors, would count as only one person for purposes of determining eligibility for the exclusion from registration under Section 4m of the Commodity Exchange Act. This position is analogous to the current treatment of entities as a Kirkpatrick & Lockhart LLP 5 single client under Rule 203(b)(3)-1 under the Advisers Act. Indeed, the CFTC stated in the adopting release that it generally intends to follow the SECs interpretations of Rule 203(b)(3)-1. Ironically, however, there is speculation that the SEC may soon change Rule 203(b)(3)-1 to look through entities. The CFTCs release does not discuss whether pools that are excluded or exempt from CPO registration pursuant to Rule 4.5 or Rule 4.13 should be counted as persons advised for purposes of determining compliance with the 15-person limitation. As adopted, Rule 4.14(a)(10) does not alter the additional statutory prerequisite of Section 4mthat a CTA not hold itself out generally to the public as a CTA. OTHER ADOPTED RULES The CFTC also adopted rule changes that (1) permit CTAs and CPOs to engage in certain types of communication with investors prior to distribution of a required disclosure document, (2) establish criteria for CPOs to distribute periodic account statements electronically, (3) harmonize the various signature requirements of Part 4 of the CFTC rules, (4) provide relief from some of the duplicative disclosure and reporting requirements in the master-feeder context, and (5) provide guidance regarding the presentation of past performance information. CARY J. MEER 202.778.9107 cmeer@kl.com MARC MEHRESPAND 202.778.9191 mmehrespand@kl.com Kirkpatrick & Lockhart LLP 6 Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States, with more than 60 lawyers devoting all or a substantial portion of their practice to this area and its related specialties. The American Lawyer Corporate Scorecard, published in April 2003, lists K&L as a primary legal counsel to the investment companies, board members or advisory firms for 15 of the 25 largest mutual fund complexes. No law firm was mentioned more frequently in the Scorecard. We represent mutual funds, closed-end funds, insurance companies, broker-dealers, investment advisers, retirement plans, banks and trust companies, hedge funds, offshore funds and other financial institutions. We also regularly represent mutual fund distributors, independent directors of investment companies and service providers to the investment management industry. In addition, we frequently serve as outside counsel to industry associations on a variety of projects, including legislative and policy matters. We work with clients in connection with the full range of investment company industry products and activities, including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of the investment company business. We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also visit our website at www.kl.com for more information, or send general inquiries via email to investmentmanagement@kl.com. BOSTON Michael S. Caccese Philip J. Fina Mark P. Goshko Thomas Hickey III Nicholas S. Hodge 617.261.3133 617.261.3156 617.261.3163 617.261.3208 617.261.3210 mcaccese@kl.com pfina@kl.com mgoshko@kl.com thickey@kl.com nhodge@kl.com LOS ANGELES William P. Wade 310.552.5071 wwade@kl.com NEW YORK Beth R. Kramer Richard D. Marshall Robert M. McLaughlin Loren Schechter 212.536.4024 212.536.3941 212.536.3924 212.536.4008 bkramer@kl.com rmarshall@kl.com rmclaughlin@kl.com lschechter@kl.com SAN FRANCISCO Eilleen M. Clavere Jonathan D. Joseph David Mishel Mark D. Perlow Richard M. Phillips 415.249.1047 415.249.1012 415.249.1015 415.249.1070 415.249.1010 eclavere@kl.com jjoseph@kl.com dmishel@kl.com mperlow@kl.com rphillips@kl.com WASHINGTON Clifford J. Alexander Diane E. Ambler Catherine S. Bardsley Arthur J. Brown Arthur C. Delibert Robert C. Hacker Benjamin J. Haskin Kathy Kresch Ingber Rebecca H. Laird Thomas M. Leahey Cary J. Meer R. Charles Miller Dean E. Miller R. Darrell Mounts C. Dirk Peterson Alan C. Porter Theodore L. Press Robert H. Rosenblum William A. Schmidt Lynn A. Schweinfurth Donald W. Smith Robert A. Wittie Robert J. Zutz 202.778.9068 202.778.9886 202.778.9289 202.778.9046 202.778.9042 202.778.9016 202.778.9369 202.778.9015 202.778.9038 202.778.9082 202.778.9107 202.778.9372 202.778.9371 202.778.9298 202.778.9324 202.778.9186 202.778.9025 202.778.9464 202.778.9373 202.778.9876 202.778.9079 202.778.9066 202.778.9059 calexander@kl.com dambler@kl.com cbardsley@kl.com abrown@kl.com adelibert@kl.com rhacker@kl.com bhaskin@kl.com kingber@kl.com rlaird@kl.com tleahey@kl.com cmeer@kl.com cmiller@kl.com dmiller@kl.com dmounts@kl.com dpeterson@kl.com aporter@kl.com tpress@kl.com rrosenblum@kl.com william.schmidt@kl.com lschweinfurth@kl.com dsmith@kl.com rwittie@kl.com rzutz@kl.com Kirkpatrick & Lockhart LLP Challenge us. www.kl.com BOSTON n DALLAS n HARRISBURG n LOS ANGELES n MIAMI n NEWARK n NEW YORK n PITTSBURGH n SAN FRANCISCO n WASHINGTON ............................................................................................................................................................ This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. © 2003 KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.